Thursday, January 11, 2018

January-February 2018 Outlook: Winter Games

The XXIII Winter Olympics start in early February, but instead of signifying a
moment of global unity, these Games may present a reminder of international
tensions. The Games are being held in PyeongChang, South Korea, just miles away
from the world’s biggest pariah nation whose nuclear program is currently the
most obvious threat to international security. Ahead of the Games, North Korea
has reopened direct contact with the South, and tensions have eased somewhat.
But the two Koreas have gone through cycles of detente before, only to see the
North go back to its antagonistic ways.

Despite the geopolitical uncertainties, the global economic environment is on
an uptrend. Equity markets have reached Olympic heights, with most equity
indices posting double digit gains on the year. Treasury yields are rising,
though there has been significant flattening in the yield curve, sparking some
speculation about the timing of the next recession. The dollar index ended the
year down about 9%, and 2018 may see more weakness in the greenback as markets
speculate that other major central banks will start to tighten policy and play
catch up with the Fed. Central bankers will be watching inflation which has
shown some signs of life, led by WTI crude climbing above $60/barrel on better
demand and surprisingly strong compliance with the OPEC production cutting
deal.

As the Winter Games get underway, the gold medal scenario for markets would
have the melt up continuing as businesses take advantage of the more favorable
tax code to invest in capex and in workers, while a refocused Congress works on
infrastructure stimulus and possibly a workable healthcare reform package. This
gold(ilocks) scenario would also see inflation continue a slow rise toward
target levels and gently rising rates at the Fed and other central banks over
the next few years.

A less glorious outcome could see companies using tax relief to pad their
dividend and share buyback programs with little new investment. Congress could
get mired in partisan contests over entitlement reform and healthcare.
President Trump’s trade rhetoric could turn decidedly protectionist, while the
Russia probe could paralyze the White House agenda. Inflation might finally
reassert its presence and spook the newly reconstituted Fed board into raising
rates too fast. Or an exogenous event like a military confrontation in Korea
could shake global markets.

Out Over Their Skis

The apex of political competition is in Washington D.C. where ‘Team GOP’ is
riding high on the passage of its first major piece of legislation after
suffering an embarrassing defeat on its healthcare initiative earlier in the
year. Congressional Republicans avoided tripping over their skis this time and
managed to rush tax reform through the gate before the end of the year.
Unfortunately for them, the plan is unpopular with the public, which perceives
it as a tax cut that largely benefits corporations and the wealthy. If this
poor public perception persists, it could prove disastrous for the GOP in the
2018 election cycle, but they have 11 months to win over voters.

Public perceptions may turn in the New Year when middle income workers see less
tax withholding in their paychecks. Many large US companies have also declared
their intentions to spread the wealth provided by tax breaks. Several firms –
most notably Walmart – have announced that they are raising the minimum wage
for entry level workers and are handing out one-time cash bonuses to
non-executive employees. The Republican tax cut has already given a boost to
the stock market as well. All of this could turn the tax cut into a clear
political victory for Republicans (at least in the short term, before the
individual tax cuts start to erode over time).

Republicans will need to muster high scores from the judges’ table because they
hope to tackle even more challenging issues in the New Year, eying bank
deregulation, GSE reforms, and comprehensive changes in healthcare and
entitlement programs. The hope is that reforms in these other major budgetary
areas can help to close the fiscal gap that will be widened by the tax plan, to
the tune of $1.5T over 10 years by most estimates.

The political realities will preclude Speaker Ryan’s Olympic-sized dreams of
wholesale changes to entitlement programs and healthcare. Any revisions will
require cooperation from the Senate, where the GOP majority has just narrowed
to 51-49, and where the tax bill just barely passed after several Republican
holdouts demanded significant changes. Some small efficiencies in entitlement
programs may be gained if the GOP can reach out to the centrist wing of the
Democratic party. A bipartisan plan for fixing some of the issues with the
Affordable Care Act has been floating around Congress, but it remains to be
seen if the leadership will support the idea, especially in the face of
President Trump declaring that he has essentially killed Obamacare by ending
the healthcare coverage mandate as part of the tax bill. An infrastructure
spending plan, depending on how it is framed, is more likely to garner support
from both parties and could lay a laurel wreath atop the increasingly
athletic-looking economy.

Anticipation of the corporate tax cut and other possible reforms boosted stocks
throughout 2017 and for the first time in history the stock market finished the
year with positive performance every single month. In the days since the
passage of the tax bill some large companies (such as AT&T and Comcast)
have declared special bonuses for workers and some new spending plans, though
it remains to be seen if these are just opportunistic public relations
announcements or if more companies will actually use the tax break for
increasing worker wages and capital spending as the Republican plan envisions.
After getting some time to study the new tax structure, many more firms will be
solidifying their spending plans and announcing guidance modifications in the
next two months. Depending on the industry – and for multinationals how much US
tax exposure they have – publically traded firms could paint a very rosy
picture under the new tax scheme (after taking a hit from the one-time tax on
stockpiled foreign profits).

While the Winter Games don’t seem to have much appeal to President Trump
personally (golf is clearly his game), he has spent a lot of time at the podium
congratulating Team GOP. Yet there are still many moguls ahead. Stock market
volatility tends to pick up early in the New Year and that could be exacerbated
by the changes in US tax code, as companies and analysts rejigger their
forecasts for Q4 and 2018 results. Stocks were up for the first five trading
days of the year, so the ‘January effect’ is in play, putting statistical
chances of the S&P500 posting another positive year at 83%. Trump continues
to pin his reputation on an advancing stock market, however, so when a
correction does eventually arise it may be at least a temporary distraction for
the Administration.

There are additional obstacles littered over the course of Washington politics
that could create other major distractions. The US government faces another
potential shutdown as the latest short term spending bill expires on January
19. The Administration wants a $100B increase in military spending while
Democrats seek a similar increase in domestic spending. Reportedly negotiators
were nearing a deal in late December, with DACA remaining the major sticking
point. This could lead to an embarrassing government shutdown and derail hopes
for other bipartisan efforts this year.

Though Russia has been banned from the Winter Games, it remains at the heart of
special investigation that haunts the White House. Despite the administration's
insistence that the probe will soon come to an end, there is no clarity about
when it will wrap up. Indications are that Mueller's investigators are trying
to leverage General Flynn and Paul Manafort into implicating officials who are
still in the White House. To date, however, there is no concrete evidence that
candidate Trump ordered collusion with Russia during the election, though his
proxies including his namesake son had encounters with some unsavory Russian
operatives in the run up to the vote last November. The latest reporting says
that President Trump could agree to be interviewed by the Special Counsel
before the end of January, but that Trump’s lawyers are pushing for a written
questionnaire so that the President can avoid open-ended, face-to-face
questioning.

Even if no more senior administration officials get caught up in the
investigation, some White House advisors could make it their New Year’s
resolution to retire from the administration. National Security Agency (NSA)
Director Mike Rogers is already planning to step out of the arena this spring
after four years at his post. Economic advisor Gary Cohn, who had a public
falling out with the President over his statements about the Charlottesville incident,
may take a victory lap on the passage of the tax cut and then return to private
life. That would be a minor blow to Wall Street which sees Cohn as its champion
in Washington, though other former financiers like Treasury Secretary Mnuchin
will still be in positions of influence. Meanwhile, Secretary of State Rex
Tillerson, who has been long rumored to be planning an exit amid policy
conflicts with the President, is now reportedly planning to continue to serve
at least through the end of 2018.

It’s All Downhill…or Cross Country

The Olympics aspire to create the highest level of competition on a fair
playing field. Global trade representatives have similar aspirations, but
sometimes domestic politics change the game. Sparked by the populist wave that
reshaped the political landscape last year, some old trade alliances are being
reshaped, for better or for worse, to meet populist demands. Cross-border trade
is only one area that is impacted by this movement as populism is threatening
to shake up the old order in Italy, and Catalonia takes another run at
independence.

The White House expected a quick rewrite of the North American Free Trade
Agreement, but Mexico and Canada pushed back against rushing a deal, and now
negotiators are looking to work into March. In the meantime, Trump
administration has taken a hard line, using trade reviews to slap duties on
Canadian lumber and its aircraft maker Bombardier. By all accounts, the
sticking points are the White House’s insistence on rules of origin and a sunset
provision that would require the three countries to renegotiate their
commitment to the trade deal every five years. The US wants rules of origin to
require over 85% of content come from within North America (up from 62% now).
Canada and Mexico argue that such a level of domestic content is not realistic
in the global supply chain and that the sunset provision would hurt confidence
and drive down long term investment.

At this point Canada and Mexico are not buying in on these concepts and the US
does not appear to be flexible, so barring a breakthrough, the White House
could announce plans to tear up NAFTA later in Q1. Six months after issuing a
formal notice, the US could dissolve the trade agreement at any time. This
could prove very disruptive for businesses that do significant cross border
manufacturing – including the likes of Ford, GM, and GE – but presumably
negotiators would start right in on bilateral trade talks. Canada and Mexico
appear to be stalling, betting that the US Chamber of Commerce, farmers, and
Congress will pressure the White House to retain the current NAFTA framework.
The forces that support NAFTA may be bolstered by public falling out between
President Trump and his former chief strategist Steven Bannon, who was seen as
the biggest proponent of protectionism in the White House. Now that Bannon is
on the outs, the trade rhetoric from the administration may soften. The sixth
round of NAFTA talks will take place in Montreal during the last week of
January.

Key trade talks are under way in Europe as well. The UK just barely managed to
salvage a preliminary agreement with the EU to close out Phase I of the Brexit
process, covering preliminary issues like citizen’s rights and the ‘divorce
bill’ settlement. By all accounts, it will be even more difficult to get the
puck across the goal line in Phase II, as talks will turn to a gloves-off trade
negotiation between the bloc and its departing member.

Britain continues to talk tough, expressing certainty that a trade deal can be
completed by March 2019 and threatening Europe with its mantra that “no deal is
better than a bad deal.” Yet the Britons seem to want to have it both ways.
Reports that the EU is making contingency plans for a ‘no deal’ Brexit scenario
have upset the UK’s chief negotiator Davis, who declared that such plans are
damaging to the process – even as London was said to be considering
establishment of a cabinet post to manage a ‘no deal’ contingency.

A new wrinkle is further complicating the Brexit talks. Just as the EU does not
compete as a bloc in the Olympics, it was revealed that they may not be acting
in unison in the Brexit trade talks. In a recent press interview, French
President Macron warned other EU leaders not to succumb to the "prisoner's
dilemma" a paradox in game theory in which two parties act out of
individual self-interest and both lose out in the process. Macron’s admonition
implies a split in the EU’s united front as Phase II gets underway.

The pound sterling may experience bouts of weakness in 2018 Brexit if negotiators
go crashing sideways into the boards like they did early in Phase I. Ultimately
though, it is in the interest of both sides to strive for a harmonious solution
rather than risk the inherent uncertainties of a ‘hard Brexit.’

Even as Brexit negotiators circle each other in the rink, Europe’s strain of
populism can be heard heckling from the cheap seats. After the Catalan
parliament voted to declare independence in late October, the body was thrown
out by the government in Madrid. But separatists climbed out of the penalty box
and regained control of the regional parliament (by a narrow margin) in
December elections, threatening to reignite a political crisis in Spain. The
two main separatist parties have agreed to reinstall Carles Pugidemont as the
parliamentary president. This will be complicated by the fact that Pugidemont
fled the country last month and is still wanted on charges of rebellion and
sedition by Spanish authorities. The Catalan leader is sure to use his exile to
his advantage, to raise sympathies over his ‘political persecution’ and to
spotlight that some of his former colleagues are still in jail on political
charges.

The political situation in Italy is not as charged, but even a symbolic victory
for populists in one of Europe’s largest economies could deal a blow to the
push for ‘more Europe.’ Italy’s President has just moved to dissolve
parliament, setting up new elections on the 4th of March. After struggling to
form a government after each of the last several elections, the mainstream
parties are at risk of an embarrassing loss at the hands of the populist party
this winter. The populist Five Star Movement (M5S) has been leading the polls,
edging out the Democratic Party (PD) led by former PM Renzi, while Silvio
Berlusconi’s Forza Italia is running a distant third. Even under the newly
constituted election laws that should favor the mainstream parties with their
stronger local party infrastructure, the M5S looks like it could skate to
victory, giving its leader, 31-year old Luigi Di Maio, the first go at forming
a new government (though, as it stands, none of the other major parties would
be willing to enter a coalition with M5S). Formed as a protest against the
political elite, the Five Star Movement has built its appeal on fighting
cronyism and corruption, but like most populist movements on the continent, it
also has euroskeptic and anti-immigrant strains. Di Maio has promised to seek
concessions from the EU and, that failing, would then call for a referendum on
Italy’s membership in the single currency. While the party has not threatened
to pursue a full Italian-style exit from the EU, a victory by M5S could put
further strains on a European Union already trying to stitch up the wounds from
the Brexit.

Inflation on Ice

In most of the developed world, inflation has been frozen at sub-optimal levels
for the last decade or longer. The era of extremely low interest rates
instituted by the global central banks has helped foster the weak inflation
environment, but now that inflation is starting to thaw, rates are beginning to
rise as well.

People have grown accustomed to low inflation, but as economic growth revives,
inflation could finally see a resurgence. CPI readings in the US and Europe
have begun to track toward the desired target levels and central banks may soon
face a question they have not had to address for the last decade: what to do if
inflation overshoots on the upside. Most central bankers looking at this
question will state that their target CPI level is symmetric and can tolerate
some periods above the desired level. But this thinking seems to presuppose
that inflation will continue to move at creeping pace, not accounting for a
potential quick spurt higher should the economy finally begins to see wage
inflation and basic materials and energy costs start to mount.

As the major central banks contemplate policy normalization over the next few
years, policy adjustments will more closely resemble the pace of a curling
match than a speed skating heat. Just recently, the Bank of Japan modestly
trimmed its daily JGB purchases, while the Bank of England got its feet wet
with an initial rate hike in November, and improved data in Europe has the ECB
on track to wrap up its QE program as soon as September. The prospects of these
other central banks playing ‘catch up’ with the Fed has been enough to keep the
dollar index at bay, but for the time being the focus remains on the Fed, which
has now raised rates five times and is prepared for at least three more hikes
this year.

The Fed team will also have a new coach in February, as Jerome Powell takes
over the Chairmanship from Janet Yellen. Powell is an experienced hand at the
Fed, having served on the Board of Governors since 2012, so he has a track
record and is a known quantity. But changes in the Fed leadership often result
in some market jitters and it will require some time to build confidence in the
new Chair. That also applies to the newest members of the Fed team being added
by Trump, which have so far been mainstream candidates after some fears that
the President might appoint radical or even anti-Fed governors. The veteran
members will take on a slightly less dovish tilt as the annual rotation of
voting members moved the two December dissenters (Evans and Kashkari) to the sidelines.

Fed officials have indicated that they are not observing any real asset bubbles
but they remain vigilant. Some members have worried aloud that the low interest
rate environment that has existed globally for such a long time could have
destabilizing effects. The implication is that it might spark ‘reach for yield’
behavior among financial investors that could be especially risky at a time
when monetary or fiscal policy can’t react if a new negative shock arises. The
Fed is also keeping an eye on the yield curve, which flattened throughout 2017.
By year end, the spread between 2-year and 10-year narrowed to below 0.50, the
lowest since before the financial crisis, and a potential early warning sign of
an impending recession.

Like the Olympic flame, the torch of inflation may flicker low but it never
dies. Ironically that flame may be stoked back into a full blaze by burning
oil. There is growing demand for raw materials of all types, illustrated by
firming prices in commodity markets, but the long-awaited rebound in energy
prices is central to the case for higher inflation. Above average global crude
inventories have been worked off by the OPEC/non-OPEC production agreement and
could come back into balance early in the second half of 2018. Compliance with
the production accord has been running at over 100% and this surprising
discipline has paid off in higher energy prices, driving WTI crude above
$60/barrel. Improving growth readings in most of the developed economies should
bolster demand for oil and further feed into inflation.

After a decade of very slow price and wage growth in developed economies, a
sudden inflation rebound might catch investors off guard in 2018. Most
economists don’t expect runaway inflation, but the US could see inflation rise
past the Fed’s 2% target to 2.5% or higher. How the Fed and other central banks
react to the data will be key. Though some above target inflation is generally
acceptable, in the Powell Fed the hawks may have more sway. Faced with a fast
moving inflation scenario, the new Fed might be tempted to push rates up
faster, which could stunt the vigorous growth that the administration is
gunning for.

The Olympic Seoul

The world’s eyes will be turned to South Korea this February as the Winter
Games get underway. There were concerns that the North Korean dictator would
find this international gathering as an irresistible opportunity to get the
world’s attention through ominous threats. Instead, the event appears to have
engendered some détente. The North has just reopened direct lines of
communication with the South for the first time in two years, leading to an
agreement for the North to send a delegation of dignitaries and athletes to the
Games. Building on this hopeful development, the usually hawkish President
Trump has toned down his rhetoric and agreed to postpone joint military
exercises during the Olympics, apparently as a sign of good faith that some
good may come from the reopened talks between the Koreas.

Unfortunately, a true breakthrough in relations between the two Koreas is about
as likely as reconciliation between Nancy Kerrigan and Tonya Harding. The North
has exhibited a certain predictable pattern in the past: A cautious
rapprochement followed soon thereafter by demands for concessions, which inevitably
leads to relations chilling again.

North Korea’s latest overture may also be an attempt to dissuade President
Trump from trying to flex his military muscles. Trump has been posturing for a
potential military conflict with North Korea, mocking Kim Jong Un as
"little rocket man" and declaring that a military solution is
"fully in place, locked and loaded." Recent reports stated that the
Pentagon has drawn up plans for a “bloody nose strike” against some of
Pyongyang’s WMD facilities. Such an attack would seek to be severe enough to
show the regime that the US is serious and capable of destroying the weapons
program. A targeted military strike would be a risky strategy, however, one
that was looked at and rejected by the last few US administrations. First it
might merely embolden the regime which can proclaim it has “withstood” a US
attack. A show of American force also risks triggering a full scale conflict on
the Korean Peninsula, one that most analysts predict would result in the
decimation of Seoul before the North was defeated.

As North Korea’s only ally, China may ultimately determine how the standoff is
resolved. For decades Beijing has helped to prop up Pyongyang both as a buffer
state between it and the US-allied South Korea and to prevent a massive refugee
crisis at its border. But it appears that Chinese thinking on North Korea has
shifted. By all accounts Chinese President Xi is not fond of the regime in
Pyongyang and he has signaled that he would not adhere to a 1961 mutual defense
treaty if North Korea provokes a conflict (in fact, Pyongyang has already
violated that pact by developing nuclear weapons).

Reports in the last month indicate that China has established a number of
refugee camps on the Korean border, indicating that Beijing fears the worst.
Some analysts are speculating that if a shooting war breaks out in the region,
China may use its growing military not to support Pyongyang, but instead to
seize control of the North. Such a bold maneuver would allow China to show off
its military prowess and exert its political influence over the eventual Korean
reconciliation process. It would also give notice to the world that China is
prepared to take on superpower status, standing on that elite podium next to
the US.

Blunting US influence in the region remains a chief goal for the Chinese
government, especially in light of the more aggressive stance President Trump
is taking on trade issues. As President Trump seeks to make good on campaign
promises about “fair” trade, he could soon decide on broad trade sanctions
against China. The Commerce Department has been assessing potential
restrictions on aluminum and steel trade on national security grounds, and
Trump could soon announce response measures based on those findings. The US is
also looking at violations of intellectual property rights and unfair
technology transfers as well as anti-dumping duties on solar panels.

Imposing tariffs on Chinese exports is likely to trigger retaliatory measures,
potentially opening up a full scale trade war between the world’s two biggest
economies. China has a number of options to push back against threats of
blanket trade barriers, perhaps the most obvious being its US treasury
holdings. A recent report said some Chinese officials were recommending “slowing
or halting” Treasury purchases because the US bonds have become less attractive
assets as they face a bear market. While it seems unlikely that China would
stop buying USTs outright, this report appears designed to give the American
government second thoughts about a direct confrontation on trade issues.

Aside from geopolitics China’s leaders continue to contend with many domestic
concerns. One such issue is maintaining a hold on currency flows as the growing
wealth class in China seeks new ways to circumvent state currency controls to
slip money offshore. This pressure has quietly made China the center of the
cryptocurrency craze that has hit the public consciousness in the last few
months.

The strength of the cryptocurrencies has always been their decentralized
control but that now may also become their Achilles heel. In an effort to clamp
down on extra-governmental currency trading China has begun to impose
restrictions on bitcoin mining. Authorities are looking at strategies to
discourage mining including raising electricity prices and writing new tax and
environmental regulations. There are also reports that South Korea is concerned
about the unregulated nature of cryptocurrencies and seek cooperation with
China and Japan to curb irrational speculation. These reports have blunted the
advance of the major cryptocurrencies in early January and virtual coins could
see more declines if other government authorities weigh in on potential
regulation. Even as nations gather to celebrate international unity at the
Games, this new borderless virtual currency is at risk of a collapse, perhaps
serving as an early warning for excessive risk-on sentiment in other assets
classes.